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Imagine an investment strategy wherein you might seek out the most successful and valuable companies. We will refer to this as the “big five” portfolio. Further, imagine that this “big five” portfolio bought the five most valuable companies in the Standard & Poor’s 500 index at each year’s end starting in 2000. Imagine further that this process was repeated each year ever since. How might this strategy of buying big and valuable stocks have done?

The strategy produced positive returns, but the journey would have been painful and frustrating (chart A, below). Investing in the “big five” at the start of each year would have returned over 155% by 2019. Yet the strategy would have been underwater with a negative return from 2000 through 2014. It would not have been until 2015 that gains would have begun to accumulate, and by that point, other simple strategies would have run far ahead. For example, the market-capitalization-weighted S&P 500 stock index was up 229%, and the equal-weighted S&P 500 index was up 458% from January 2000 through January 2020. Owning top-shelf and well-known names would not have turned out to be a very good strategy, after all.

Chart A
“Big Five” Strategy vs. S&P 500

A New Record

It is also interesting to keep an eye on how value the top five mega-cap stocks are relative to the economy’s size (chart B, below). To do this, we divide the total value of the five most valuable U.S. stocks by the country’s gross domestic product (GDP). Today, the five largest U.S. companies’ value is 35% of the U.S. economy — a record. The previous peak was 1999 when the five largest firms were valued at just over 20% of GDP.

Chart B
Market Capitalization of 5 Most Valued Stocks (% GDP)

To be fair, it must be noted that today’s mega-cap companies are extremely profitable. Fundamentally, the five largest companies produce revenue equal to roughly 5% of GDP — both in 2000 and now. But profitability by the “big five” are much greater today than back in 2000. Today the “big five” generated net profits equal to 14% of assets, twice the profitability of 2000. Producing more revenue and earnings with less capital marks a massive change in efficiency, mainly due to the shift toward a digital economy. To be fair, higher profits should fetch a higher valuation, but much of the higher profitability now seems priced in.

An Active Alternative

Investment strategies that systematically put more money in highly valuable stocks tend to struggle when markets become discriminating over price. Indices like the S&P 500 and many others are market-capitalization weighted. This means that highly valued firms are weighted more heavily in the index. When following such a process, it is helpful to remember that there can be drawbacks to size. Larger companies can become the target of anti-trust and regulatory pressure. Replicating past success and delivering high growth can become difficult with size, placing managements under intense pressure. Rapidly growing firms can end up with large and sprawling organizations and may increasingly turn to acquisitions to fund growth. All of these drawbacks can increase risk. For these reasons, it pays to maintain pricing discipline and avoid adding to positions just because the market assigns a high valuation to any one firm.

We believe the market-cap weighted nature of most market indices creates an opportunity for active management. An actively managed portfolio that focuses on factors other than market size can be one way to avoid some of the pitfalls that can come with owning very highly-valued stocks. As the “big five” companies in the U.S. approach a collective valuation near 35% of GDP, a record, it may make sense to consider an active approach.

Kevin R. Caron, CFA
Senior Portfolio Manager

Chad Morganlander
Senior Portfolio Manager

Matthew Battipaglia
Portfolio Manager

Steve Lerit, CFA
Client Portfolio Manager

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income

Suzanne Ashley
Internal Relationship Manager

Eric Needham
External Sales and Marketing

S&P 500 — The Standard & Poor’s 500 Index is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

The S&P 500 High Beta Index measures the performance of 100 constituents in the S&P 500 that are most sensitive to changes in the market. Constituents are weighted relative to their level of market sensitivity, with each stock assigned a weight proportional to its beta.

The S&P 500 Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.


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